Tarapore against use of forex reserves to fund core sector

Former Reserve Bank of India (RBI) deputy governor S S Tarapore today joined the on-going debate on the use of foreign exchange reserves for infrastructure financing.

Delivering a speech on "Indian Macroeconomic Perspectives and Monetary Policy Dilemmas" to the Havard MBA Class today at JM Morgan Stanley today, Tarapore said: "... the idea of using forex reserves for infrastructure investment is a false start."

The appropriate way, according to him, would be to give a domestic impetus to various infrastructure projects and to the extent there is a forex component it would be fully met by drawing on the forex reserves.

However, he warned that there should not be a situation wherein the RBI provides both rupees and forex resources. The rupee resources to buy the foreign exchange from the RBI must necessarily come from a source other than the Indian central bank, he said.

In other words, there should not be a violation of the RBI balancesheet. "A special purpose vehicle would be a mere fig leaf for eroding the sanctity of the RBI balancesheet," he said.

Further, the repeal of the Fiscal Responsibility and Budget Management Act and restoration of the obnoxious practice of monetising the government deficit would be a retrograde step.

He also dropped a hint that the domestic interest rates should rise.

"With the US interest rates inching up, Indian interest rates would also need to rise," he said.

The present Indian inflation rate is 6.5 per cent, while the comparable rate in the US is 3.5 per cent. At present there is the complication for the Indian authorities of the Indian yield curve being totally flat.

With the Indian 10-year yield at 6.8 per cent and the US rate at 4.2 per cent, the premium on the US dollar would need to be around 2.6-3.0 per cent but in actual fact it is only 1.75 per cent, Tarapore said.

Thus, there is a strong incentive to move funds into India. There is the added complication with the short end of the yield curve being relatively high and the inflation rate differential is in the region of three per cent (Indian rates are higher). If Indian short rates were jacked up, the inflows would be even stronger, he pointed out.

Praising the RBI for a "superb juggler's act", Tarapore said the Indian central bank has nudged up the 10-year gilt rates by about two percentage points over the past year, without large increases at the short end.

Thus, some limited correction of Indian interest rates has been achieved without encouraging large and volatile short-term inflows.